Two Important Considerations When Deciding How to Invest Your Money

Keeping These Important Truths In Mind Can Protect Your Portfolio and Net Worth

•••
Keeping two considerations in mind when thinking about how to invest your money can make the journey to financial independence a lot easier, as well as provide comfort knowing that you have some measure of protection when times get tough due to your foresight and discipline.
Cimmerian / E+ / Getty Images

Learning how to invest is one of the most rewarding, and lucrative, skill sets you can acquire in your lifetime. Not only can it help you build wealth and live off a stream of passive income such as dividends, interest, and rents, but it can let you sleep soundly at night as it becomes much easier to manage your risk, protect against fraud, and arrange your financial affairs so that you aren't exposed to losses that could force you to lower your standard of living. In this introductory article, I want to walk you through the basics of how to invest your money; cover some simple concepts that will give you a decent lay of the land so you know how to proceed.

The First Thing About Learning How to Invest Your Money Is Understanding That Your Job is to Acquire Cash Flows

This might sound overly simplistic but it is absolutely essential that you get this concept. Everything - stocks, bonds, real estate, private businesses, intellectual property, synthetic equity, all of it - is useful to you as an investment only insofar as it is capable of being converted or throwing off spendable cash for you at some point in the future in an amounts that, adjusted for risk, inflation, taxes, and time, rewards you for for forgoing the use of your funds today. In the past, I've indirectly referred to this concept on my personal blog by describing it as my "two levers philosophy of cash flow", occasionally revisiting it in-depth in articles such as this one.

No matter what assets you acquire or the legal entity or account structure through which you acquire it, you must always be aware of what is actually happening, at the lowest level, to bring in surplus cash for you. What is the economic activity? Is it sustainable? What are the risks that could endanger it?

Let me give you an example. Imagine you open a Roth IRA. You contribute $5,500 to it, which is the 2016 limit for investors younger than 50 years old. You then invest this money in shares of an S&P 500 index fund. As of today, February 28th, 2016, 3.158469% of your money is going to be invested in Apple. That is, roughly $1.00 out of every $31.66 you have is at work in ownership of the California-based technology giant. When you actually dig down into the company's operating results by studying the balance sheet and income statement found in the annual report and Form 10-K filing, you see that almost 58% of the intrinsic value of the company comes from selling iPhones.

In practical terms, that means 1.83% of your investments are tied directly to the success of the iPhone. If Apple were to lose its dominance to some other, smaller firm that is not part of the S&P 500, no matter what the stock market did in the short-term, long-term, you're going to see that wealth wiped off of your personal net worth. The reason: In the end, what really counts is the cash that is being generated for you. That index fund you see, which doesn't even really exist, is a pooled basket of stocks.

Those stocks are ultimately only worth the cash flows they produce for you, as the owner. These cash flows manifest as total return but if the cash flows dry up, ultimately, too, will the stock.

The bottom line: You cannot escape economic reality. Investors try from time to time - they bid up new IPOs to the sky and make folks think they are getting rich overnight - but in the end, underlying profits are what make sustainable fortunes. Furthermore, what you pay for those cash flows is the ultimate determinant of your compound annual growth rate. Always know how the cash is being generated. Always know what you are paying for the earnings stream. If you can't spell it out in a few sentences on an index card, your gambling, not investing.

To learn more about this, read Market Timing, Valuation, and Systematic Purchases.

The Next Thing About Learning How to Invest Your Money Is Understanding How to Protect Yourself and Minimize Taxes

Once you have selected the assets you want to acquire and that will be pumping out income for you, you want to place those assets in a structure or account that enjoys maximum tax and asset protection advantages. These are two distinct considerations that must be taken together.

Whether it's using a family limited partnership or a trust fund, a SIMPLE IRA or a 401(k) plan, each legal structure and account type has its own benefits and drawbacks. For example, last year, in 2015, if you were not covered by a retirement plan at work, money contributed to a Traditional IRA (you could contribute $5,500 if you are younger than 50 or $6,500 if you are older than 50 but less than 70.5 years old) received a tax write-off as long as you didn't exceed the income limits. If you were single and earning an adjusted gross income of $61,000 or less, or married filing jointly and earning an adjusted gross income of $183,000 or less, you could deduct the contribution from your taxable income.

On top of this, any money earned within the Traditional IRA until you make a withdrawal at the age of 59.5 years or older isn't subject to taxes. Instead, you pay taxes on withdrawals, adding the amount you take out of the Traditional IRA to your income.

Above and beyond this, the Traditional IRA has certain asset protection benefits. In 2015, up to $1,245,475 of your money held within your combined Traditional IRAs and Roth IRAs is protected in the event you have to declare bankruptcy. For plans such as SEP-IRAs and 401(k)s, there is no limit to the bankruptcy protection. This means if something catastrophic happened, you wouldn't want to start making withdrawals from these accounts to, say, save your home from going into foreclosure. If push comes to shove and you have to throw yourself at the mercy of the bankruptcy court, you want to be able to walk out of the courthouse doors with your retirement plan still intact, compounding for you after your debts have been discharged.

Put another way, the exact same assets can behave very differently for you in terms of how efficiently they grow your net worth depending upon where they are placed. This is a strategy known as asset placement.